For the first time in a very long time, it appears that interest rates are headed higher. Inflation remains below the Federal Reserve's target of 2 percent, but it is rising and there is growing expectation that it will soon become something more to fight than to hope for.
The Fed seems convinced. Last month it raised rates a quarter point, to the range of 1. While year bond prices have recovered slightly from their fall early this year, most analysts expect the year yield to continue moving higher and to finish the year above 3 percent. More from Fixed Income Strategies: Where the bonds are: The outlook for fixed income Fixed income investments to jump on The growing popularity of bond funds for investors is due to the simple fact that they are the simplest, cheapest way for investors to buy a diversified basket of bonds.
Investors can buy the broad market of government and corporate bonds, they can target international fixed-income markets, or they can invest in slices of the market or sectors therein. Bond funds offer a degree of diversification that only large scale can bring. Yeske currently has his clients' bond allocations parked in funds with a duration of only one year, and he never stretches beyond three to five years' average duration. A funny thing has been happening in the bond market lately.
Bond yields had been falling for three years—and, indeed, with ebbs and flows since The year Treasury yield hit a record closing low of 1. But since then, bond prices, which move inversely from their yields, have been sliding—a fall that has gathered momentum since Election Day amid predictions of faster growth and rising inflation under a Trump administration and the growing likelihood that the Federal Reserve will raise short-term interest rates in December and perhaps several more times in On November 23, the year Treasury yielded as much as 2.
Is this the beginning of the end for the year-old bond bull market or just a head fake? But I do know this: Bond yields have been ridiculously low for years now. The bond market is in a dangerous bubble, and bubbles always end badly. But keep your bond durations short, really short. With that in mind, here are my five favorite bond mutual funds for , in order from safest to riskiest. My picks are primarily designed to limit losses in a rising-rate environment. Returns are through November The fund benefits from a low annual expense ratio of 0.
On the other hand, slower economic growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown is also typically bad for corporate profits and stock returns, adding to the attractiveness of bond income as a source of return. If the slowdown becomes bad enough that consumers stop buying things and prices in the economy begin to fall — a dire economic condition known as deflation — then bond income becomes even more attractive because bondholders can buy more goods and services due to their deflated prices with the same bond income.
As demand for bonds increases, so do bond prices and bondholder returns. In the s, the modern bond market began to evolve. Supply increased and investors learned there was money to be made by buying and selling bonds in the secondary market and realizing price gains. Until then, however, the bond market was primarily a place for governments and large companies to borrow money.
The main investors in bonds were insurance companies, pension funds and individual investors seeking a high quality investment for money that would be needed for some specific future purpose. As investor interest in bonds grew in the s and s and faster computers made bond math easier , finance professionals created innovative ways for borrowers to tap the bond market for funding and new ways for investors to tailor their exposure to risk and return potential.
The U. Broadly speaking, government bonds and corporate bonds remain the largest sectors of the bond market, but other types of bonds, including mortgage-backed securities, play crucial roles in funding certain sectors, such as housing, and meeting specific investment needs.
Gilts, U. A number of governments also issue sovereign bonds that are linked to inflation, known as inflation-linked bonds or, in the U. But, unlike other bonds, inflation-linked bonds could experience greater losses when real interest rates are moving faster than nominal interest rates.
Corporate bonds : After the government sector, corporate bonds have historically been the largest segment of the bond market. Corporations borrow money in the bond market to expand operations or fund new business ventures. The corporate sector is evolving rapidly, particularly in Europe and many developing countries. Speculative-grade bonds are issued by companies perceived to have lower credit quality and higher default risk than more highly rated, investment grade companies.
Within these two broad categories, corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly.
Speculative-grade bonds tend to be issued by newer companies, companies in particularly competitive or volatile sectors, or companies with troubling fundamentals. While a speculative-grade credit rating indicates a higher default probability, higher coupons on these bonds aim to compensate investors for the higher risk.
Ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve. Emerging market bonds : Sovereign and corporate bonds issued by developing countries are also known as emerging market EM bonds. Since the s, the emerging market asset class has developed and matured to include a wide variety of government and corporate bonds, issued in major external currencies , including the U.
Because they come from a variety of countries, which may have different growth prospects, emerging market bonds can help diversify an investment portfolio and can provide potentially attractive risk-adjusted returns. Mortgage-backed securities and asset-backed securities are the largest sectors involving securitization. Credit spreads adjust based on investor perceptions of credit quality and economic growth, as well as investor demand for risk and higher returns. After an issuer sells a bond, it can be bought and sold in the secondary market, where prices can fluctuate depending on changes in economic outlook, the credit quality of the bond or issuer, and supply and demand, among other factors.
Broker-dealers are the main buyers and sellers in the secondary market for bonds, and retail investors typically purchase bonds through them, either directly as a client or indirectly through mutual funds and exchange-traded funds. Bond investors can choose from many different investment strategies, depending on the role or roles that bonds will play in their investment portfolios.
Passive investment strategies include buying and holding bonds until maturity and investing in bond funds or portfolios that track bond indexes. Passive approaches may suit investors seeking some of the traditional benefits of bonds, such as capital preservation, income and diversification, but they do not attempt to capitalize on the interest rate, credit or market environment.
Active investment strategies, by contrast, try to outperform bond indexes, often by buying and selling bonds to take advantage of price movements.
The interest rate environment affects the prices buy-and-hold investors pay for bonds when they first invest and again when they need to reinvest their money at maturity. This is the most common type of yield curve. Longer maturity bonds usually have a higher yield to maturity than shorter-term bonds. When these points are connected on a graph, they exhibit a shape of a normal yield curve.
Such a yield curve implies stable economic conditions and should prevail throughout a normal economic cycle. The blue line in the graph shows a steep yield curve. It is shaped like a normal yield curve with two major differences.
Second, the yields are usually higher compared to the normal curve across all maturities. Such a curve implies a growing economy moving towards a positive upturn.
Such conditions are accompanied by higher inflation, which often results in higher interest rates. Lenders tend to demand high yields, which get reflected by the steep yield curve. Longer-duration bonds become risky, so the expected yields are higher. A flat yield curve, also called a humped yield curve , shows similar yields across all maturities. A few intermediate maturities may have slightly higher yields, which causes a slight hump to appear along the flat curve.
These humps are usually for the mid-term maturities, six months to two years. As the word flat suggests, there is little difference in yield to maturity among shorter and longer-term bonds. Such a flat or humped yield curve implies an uncertain economic situation.
It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown. It might appear at times when the central bank is expected to increase interest rates.
In times of high uncertainty, investors demand similar yields across all maturities. The shape of the inverted yield curve, shown on the yellow line, is opposite to that of a normal yield curve.
It slopes downward. An inverted yield curve means that short-term interest rates exceed long-term rates. An inverted yield curve is rare but is strongly suggestive of a severe economic slowdown.
Historically, the impact of an inverted yield curve has been to warn that a recession is coming. Yield curves change shape as the economic situation evolves, based on developments in many macroeconomic factors like interest rates, inflation, industrial output, GDP figures, and the balance of trade. While the yield curve shouldn't be used to predict exact interest rate numbers and yields, closely tracking its changes helps investors to anticipate and benefit from short- to mid-term changes in the economy.
Normal curves exist for long durations, while an inverted yield curve is rare and may not show up for decades. Yield curves that change to flat and steep shapes are more frequent and have reliably preceded the expected economic cycles.
For example, the October yield curve flattened out, and a global recession followed. Interpreting the slope of the yield curve is useful in making top-down investment decisions for a variety of investments. If you invest in stocks and the yield curve says to expect an economic slowdown over the next couple of years, you might consider moving your money to companies that perform well in slow economic times, such as consumer staples.
If the yield curve says that interest rates should increase over the next couple of years, investment in cyclical companies such as luxury-goods makers and entertainment companies makes sense. Real estate investors can also use the yield curve.
While a slowdown in economic activity might have negative effects on current real estate prices, a dramatic steepening of the yield curve, indicating an expectation of inflation, might be interpreted to mean prices will increase in the near future.
Of course, it's also relevant to fixed-income investors in bonds, preferred stocks, or CDs. When the yield curve is becoming steep—signaling high growth and high inflation—savvy investors tend to short long-term bonds. They don't want to be locked into a return whose value will erode with rising prices. Instead, they buy short-term securities.
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